Is Active Management Worth the Cost?

Many individual investors wonder whether they should invest in “passive” index funds or in their actively managed cousins. In this post, we will take a look at the differences between them.

Index funds, whether exchange traded (ETFs) or mutual funds, are constructed to reflect the components of a market index, such as the S&P 500 or the Russell 2000. Their goal is not to outperform the selected index but to mirror its performance. These funds provide broad exposure to a market index by including a representative group of securities.

Actively managed funds attempt to outperform a particular index. Managers rely on their knowledge, research, timing, and market views to buy and sell stocks that they think will perform better than the benchmark.

Here are the major factors to consider in weighing the relative merits of active and passive funds:

Performance

Fees and costs

Tax considerations

Performance: In theory, it makes sense that active managers should be able to use their insights to choose securities that will do better than an index. However, many studies have shown that over time, almost all actively managed funds underperform their benchmarks, even before fees and taxes are factored in.

In “Rules of Prudence for Individual Investors,” MIT professor Mark Kritzman compared the hypothetical returns of an index equity fund, an actively managed equity fund and a hedge fund over a 10-year time horizon, adjusting for fees, costs and taxes. Even using aggressive pre-tax return assumptions for the actively managed funds—13.5% for the stock fund and 19% for the hedge fund—compared to 10% for the index fund, he concluded that just to equal the performance of an index fund after factoring in fees, costs and taxes, an actively managed equity fund would have to outperform an index fund by an average of 4.3% per year. A typical hedge fund, he concluded, given its extreme tax-inefficiency, would need to beat the index fund by 10% per year.

Fees and costs: Because of the extra resources that must be dedicated to actively managing a fund, fees are typically between 1% and 2%, much higher than those of passively managed funds. Further, an active manager generally makes a lot more trades in order to implement their vision; those trading costs are charged against the fund. The fund’s return is reduced by the combination of fees and costs, probably meaning that its relative underperformance is further increased.

Taxes: A passively managed fund typically has lower turnover than an actively managed fund. When stocks in an index fund increase in value and the fund holds on to them, there is no realized gain. When active managers change the lineup of stocks in their funds, gain is realized on each of the appreciated stocks. This realized gain is passed on to the shareholders, who then must pay taxes on the capital gain.

Although we favor passive funds in most markets, we may consider active managers for two very different asset classes: emerging market stocks and fixed-income securities.

The characteristics of emerging markets may justify active management. “Mature” markets, like those reflected by the S&P 500 and other major stock market indexes, are relatively efficient—meaning it’s difficult to identify equities that are undervalued or overlooked. But in less efficient markets—where rules are not as stringent and securities are not as liquid—active managers that understand their sectors and conduct exhaustive due diligence may, in fact, be able provide results that more than offset the added costs of those services.

In the bond market, active fixed-income managers closely scrutinize credit quality, duration, sector, and liquidity. Extensive research can help reduce default rates—important in today’s environment. Even in the fixed-income market, though, active management has not historically outperformed indexes.

Before investing in an actively managed fund because the manager’s approach seems compelling, we recommend that you consider all of these factors.